Getting Smart About Your Debt

June 28th, 2012

Strategies for Managing Debt During Difficult Financial Times

Americans’ recent push to eliminate their debt is placing many families at risk. The most recent Federal Reserve Bank of New York Quarterly Report on Household Debt and Credit shows that Americans reduced their debt by approximately $100 billion since the fourth quarter of 2011 (Details here). However, Americans who reduce debt without setting up a plan to manage it, risk their long-term financial security.

Cash flow is king. Taking on debt can help you make large purchases such as a home or pay for higher education. However, taking on too much debt reduces cash flow for retirement plans, savings, and can dramatically limit an individual’s ability to accumulate wealth. By building a plan, individuals can balance debt and cash flow today to ensure success in the future.

This is particularly relevant as American families continue to deal with the long-lasting effects of the Great Recession. Between 2007 and 2010, the median net worth for an American family fell 38.8 percent (Details here). The use of debt remains an important financial reality for many Americans. And smart debt management can help Americans as they seek to rebuild their net worth.

Consumers should consider five key points when deciding to take on debt:

The duration of assets and liabilities: Consumers should be hesitant to take out short-term loans to finance long-term assets. For example, financing a long-term asset such as a home with short-term loans from credit cards is an ill-advised decision. When payment comes due at the end of the month for your credit card, you won’t be able to use the value from your home to pay the bill. By the same token, borrowing long-term for a short-term asset can spell trouble as well. Taking a 10-year loan for a used car that won’t make it until next year leaves you with debt years after the car you purchased is already in the junkyard.

Your Liquidity: Sometimes it is not possible to perfectly match the duration of our assets and liabilities. In this case, take your liquidity into account when deciding to take on debt. For example, you might decide to refinance your mortgage at a lower rate, without increasing the outstanding balance. However, to take advantage of this strategy, you may need liquidity in the form of cash to pay the refinancing’s upfront costs and points.

Interest rate risk: What happens to your debt when interest rates rise? If you borrowed money at a variable interest rate, such as a margin loan, the cost of the loan will track the increased level of interest rates. If, at the same time, increased interest rates negatively impact your asset holdings, you may experience a classic margin squeeze. It’s important to assess the amount of interest rate risk exposure that is in your balance sheet. A CFP® professional can help you make this determination.

Financial Priorities: You may be determined to get those credit card balances eliminated as soon as possible. However, it may be wiser to direct your extra cash first toward 401(k) contributions in order to get an employer match, or to set up an emergency fund, so you have some protection should unexpected expenses arise. It is a question of balancing your short- and longer-term priorities in a way that makes most sense for your individual circumstances.

Ratio of discretionary to non-discretionary expense: Most debt has to be serviced every month, thus becoming a recurring fixed, non-discretionary expense. The larger these expenses, as compared to other expenses that you have more control over in terms of their amount and when they are paid, the less planning room you have to react to changing circumstances. This is particularly important to retirees who may be living off of their investment portfolios. When the market takes a steep drop, the best strategy is to avoid taking money from investments. But if you have a large debt burden, this may not be possible. Taking this risk into account, it may be advisable to eliminate debt, even when interest rates on loans seem extremely favorable.

Your debt needs to be considered in the context of all your financial circumstances and needs. What is right for one individual in terms of the appropriate amount and cost of borrowing may be wrong for another.

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